If you’ve been paying attention to the headlines, you’ll know that the pandemic has caused a significant amount of stock market volatility in the last year. Disruptions like these can easily make you worry about your long-term financial wellbeing.
A common way that financial planners seek to generate positive returns is by diversifying your portfolio.
To find out more about what this strategy could do for you, read on to find out the benefits of diversifying your portfolio.
Diversification involves mitigating risk by investing in a variety of different assets
Essentially, diversifying your investments means spreading risk. As the old saying goes: “Don’t put all of your eggs in one basket!”
A diverse portfolio is one that invests in a variety of asset classes with different levels of risk. It also involves investing across a variety of industries and economic sectors on a global scale.
By spreading the risk, you can reduce the impact that an economic shock can have on one area of your portfolio. In theory, a fall in one area of your investments can be offset by improved performance in another.
For example, many airlines have struggled due to the international travel restrictions caused by the pandemic. If you had invested all of your wealth in airline shares, you would probably have lost money.
However, if you had split your investment between airlines and pharmaceuticals, which have performed well during the pandemic, the growth in the latter could have softened the fall in value of the former. This means that the impact on your portfolio would be lessened.
The principle is the same when investing in different assets. There are essentially four main asset classes:
Equities
When you buy equities, you’re buying a share in a company. If the company’s share price rises, you will often be paid a dividend, so you end up profiting from buying the equities. However, shares are typically considered a high-risk asset as share prices can fall as well as rise.
Bonds
Essentially, when you buy a bond you loan money to the company or organisation you bought it from. In return, they will then make interest payments on that loan. Bonds are usually considered to be lower risk, but this also means that they offer smaller returns in the long term.
Property
Tangible assets, such as property or gold, form their own asset class. These investments typically have a higher risk attached.
Cash
The lowest-risk asset that you can hold is cash. As a result, returns on cash investments tend to be low. This asset can be suitable for people who are risk averse and not looking for long-term growth.
Diversifying your portfolio can lower risks, consolidate gains, and boost returns
If you’re looking to build your wealth, making sure you have a diverse portfolio is one of the most important things you can do. Here are five ways in which diversification can benefit you:
1. Minimise risk
As the coronavirus pandemic has demonstrated, markets generally respond poorly to uncertainty. Major events can affect prices and even short-term disruptions can negatively impact your investments.
With a diversified portfolio, if one of your asset classes is performing poorly, this may be offset by growth in other areas. The same is true geographically, as not all countries and regions are affected equally by the same issues.
Market research published in FT Adviser also suggests that portfolios containing sustainable ESG-linked assets could be less prone to market volatility in certain market conditions. If you want to know about this, read our article to find out how ESG investing has fared during the pandemic.
2. Consolidate your gains
One possible option as you approach retirement is to consider investing in lower-risk assets.
While you may see smaller returns with this strategy, you could gain more financial security.
By diversifying your assets into choices such as cash or bonds, you may be able to reduce the risk to your wealth, giving you more peace of mind.
3. Limit regional bias
One issue with investing is the psychological effect called the “home country bias”. This is an investor’s natural tendency to prioritise investing in their own country’s businesses.
While this may be understandable, it isn’t always the most sensible financial decision as it limits your choices.
Since diversification also involves a geographical spread, it can help you to grow your wealth more effectively by seeking investment opportunities across the globe.
4. Increase your chances of generating returns
If you rely too heavily on just one asset class, it places it under significant pressure. While strong performance could result in significant returns, poor performance could equally result in large losses.
Furthermore, when the market does fall, some asset classes may recover more quickly from the economic shock than others.
Diversifying means spreading the risk of a portfolio but also the possibility of rewards. By not being too reliant on only one asset class, region, or sector, you can improve your chances of seeing a return on your investments.
5. Provide greater opportunity
Not being constrained by only one industry, region, or asset class, a properly diversified portfolio can invest much more widely.
This can improve your chances of finding areas where you can make more lucrative gains than you might have done with a narrower focus.
Diversification is a useful tool that allows you to reduce the risks to your portfolio and grow your wealth in a much more effective way.
Get in touch
If you want to know more about how a diverse portfolio can help you to reach your investment goals, get in touch. Please email info@investmentsense.co.uk or call 0115 933 8433.
Please note:
The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
